Executive Compensation and "Informed" Decisions: Delaware Law and the Problem of Compensation Consultants

We have from time to time discussed the role of compensation consultants in the realm of executive compensation.  Their role is critical.  Under Delaware law, a board decision on executive compensation is all but free from legal challenge if approved by "independent" directors and done on an "informed" basis.  We have talked at great length on this Blog how the Delaware courts use, among other things, excessive pleading standards to terminate any examination of the independence of directors and apply inconsistent tests by, among other things, excluding consideration of the amount of fees paid to the director.  As a result, there are directors who make in the vicinity of $700,000 a year who are treated as independent.  The topic is discussed at great length in Disloyalty without Limits.

Similarly, the notion that directors are "informed" when they approve lucrative pay packages (that can involve personal use of the corporate aircraft, golden coffins (payments after the CEO dies), elaborate security systems and the purchase of the CEO's house, in addition to compensation that seems to go up irrespective of whether the company's share prices go down.  In making these "informed" decisions, the board need only have an appropriate report from a compensation consultant to justify any amount paid. 

Compensation consultants, however, often perform other functions for the company and therefore can easily have conflicts of interest that impair the neutrality of their report.  They can, as testimony with respect to Countrywide recently illustrated, become advocates, not for the company, but for the officer whose compensation is under review.  In other words, a board is relying on a advocate for the CEO in deciding whether the compensation is fair.   

That was the subject of an article by Gretchen Morgenson in the Sunday New York Times.  She noted the conflicts of interest and concluded that there was an easy fix:  "Require companies to detail in proxy statements all fees paid to consultants they hire, for compensation design and all other services."

In other words, a problem with state law must be shifted to the SEC for resolution, with disclosure as the primary mechanism to ameliorate the matter.  In fact, it should be state law and a board's fiduciary obligations that prevent the use of compensation consultants with conflicts of interest.  But it is unrealistic at this stage of the race to the bottom to expect the Delaware courts to make fiduciary obligations meaningful.  As a result, there is increasing preemption of state law matters by the federal regulatory regime. 

As we have noted in the past, correcting a problem of governance solely through disclosure can be problematic.  As my piece, Corporate Governance, the SEC, and the Limits of Disclosure, chronicles, disclosure designed to affect substantive behavior does not always work.  Thus, even with the disclosure of the conflicts of interest incurred by compensation consultants, there is nothing that actually prevents boards from still using the consultants.  This was the case with "independent" accounting firms that had lucrative consulting arrangements with the companies they audited.  Disclosure was not enough to ensure independence.  Instead, it took SOX and the mandatory separation of accounting and consulting to make it happen.

Disclosure is a beginning, and amendments to Item 402 to require disclosure of all arrangements with compensation consultants would be useful.  But in the absence of stepped up standards under state law, it may well be the case that the only way to ensure the independence of the firms is to undertake a federally mandated separation.  Store this away for SOX II.